Accounting Problems at Fannie Mae Page: 4 of 6
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CRS-4
uses derivatives extensively to manage risk. For example, if Fannie had a portfolio of
bonds that would decline in value if interest rates rose and wished to protect itself against
that potential loss, it might purchase a derivative that would gain value by an equal
amount as rates went up. The OFHEO report finds major problems in Fannie's
accounting for the value of these financial instruments.
Derivatives accounting is governed by SFAS 133.' Under SFAS 133, the fair value
of all financial derivatives must be calculated ("marked-to-market") at the end of each
accounting period. Changes in fair value from the previous accounting period must be
reported as current income, unless the derivatives are used for hedging. If a derivative is
used to hedge an asset (as in the example above), the value of that asset - the hedged
item - will move in the opposite direction to the derivative's value. Thus, a fall in the
price of the hedged asset will be offset by a gain in the derivative (or vice versa). Under
SFAS 133, the firm can recognize as earnings both the change in the derivative's value
and the offsetting change in the hedged item's. If the gains and losses are closely
correlated, the net effect on reported earnings will be very small or zero.
There is another form of hedge accounting under SFAS 133, covering derivatives
held to hedge a future transaction or cash flow. Since the hedged item in this case does
not yet exist, it cannot be marked to market and used to offset gains in the derivative's fair
value. However, SFAS 133 allows the gain or loss in a derivative used to hedge a future
event to be assigned to comprehensive income, a subcategory of stockholders' equity.
When the future transaction or cash flow occurs, the derivative is marked to market and
changes in fair value are recognized as current income, but presumably gains or losses in
the derivative will be offset by the hedged item.
Either form of hedge accounting has the effect of reducing the impact of changes in
derivatives' fair value on current earnings and the bottom line. To qualify for this
accounting treatment, however, SFAS 133 requires that there be a close relationship
between changes in the value of the derivative and the hedged item. Derivatives that do
not meet FASB's hedge test are considered speculative trading instruments, and changes
in fair value from period to period must be recognized and reported as current earnings.
The OFHEO report identifies several problems with Fannie Mae's compliance with
SFAS 133. The most general problem was also a major issue in Freddie Mac's 2003
accounting restatement: "many of [Fannie Mae's] hedging relationships should not qualify
for hedge accounting treatment."8 Because Fannie Mae does not properly measure the
"effectiveness" of its hedges - the correlation between changes in the value of the
derivative and the hedged item - they do not meet FASB's hedge test. In many cases,
OFHEO finds that Fannie simply assumes perfect effectiveness (that changes in the
derivative's fair value and the hedged item's value will exactly offset each other) and fails
to perform the calculations and maintain the documentation that SFAS 133 requires.
OFHEO analyzes a number of derivatives transactions in detail and finds numerous
specific practices that do not conform with SFAS 133. A common theme is the
inappropriate use of "short-cuts" that produce the desired result of perfectly effective
7 See CRS Report 98-52, Derivatives: A New Accounting Standard, by Mark Jickling.
8 OFHEO, Report of Findings, p. 113.
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Jickling, Mark. Accounting Problems at Fannie Mae, report, December 16, 2004; Washington D.C.. (https://digital.library.unt.edu/ark:/67531/metadc806929/m1/4/?q=%22executive%20departments%22: accessed May 22, 2024), University of North Texas Libraries, UNT Digital Library, https://digital.library.unt.edu; crediting UNT Libraries Government Documents Department.